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Decisions, Decisions

Investment options for retirees are
mind-boggling. Here's what the experts recommend.

By

Kara Fitzsimmons

Updated Oct. 6, 1997 11:59 p.m. ET

It's a soup out there.

Stocks, bonds and mutual funds; variable annuities and life insurance; and every flavor of trust, from irrevocable insurance to charitable remainder.

What are investors to do with their retirement savings?

The answers are never the same. Every retiree starts with a different nest egg, in different tax brackets and with different goals and risk tolerances. In addition, financial professionals hold differing opinions about appropriate investments, and are influenced by how they're paid -- fee, commission or both.

And, yet, some investments and techniques continue to make retirees' most-wanted lists. "There's no such thing as the 'best' product," says Dean McGill, a field vice president at American Express Financial Advisors in Walnut Creek, Calif. "But, quite frankly, it's the old standbys I find myself using more and more."

So what are those favorites? Here's a look at some of the most common investment products and strategies that financial professionals recommend for retiring clients.

Sell Company Stock

As their careers wind down, growing numbers of people find they hold large bounties of their company's stock in their retirement plans. So long as the stock is in a tax-deferred shelter such as a 401(k) plan or individual retirement account, retirees may want to liquidate and reallocate at least part of their holdings for diversification's sake. A bad earnings announcement, say, could pummel a stock -- and a retiree's portfolio along with it.

"I'm sure somebody sitting there with Microsoft [stock] is laughing at me," says Lee Rosenberg, a financial planner at ARS Financial Services Inc. in Valley Stream, N.Y. "But I doubt anyone wants to have all of their fortunes tied to one company."

If the stock isn't tax-protected, selling shares can generate a hefty bill. Thomas Gau, an adviser with Kavesh & Gau Inc. in Torrance, Calif., encountered a soon-to-be retiree with AT&T Corp. stock whose adviser told him to sell it -- all $800,000 of it. A lot of that stock was outside the investor's retirement plan, and selling would have filled the pockets of the Internal Revenue Service. A better strategy was to diversify by selling what AT&T stock he held within the plan.

Use common sense, Mr. Gau says. If your company is established and healthy, there's no reason to dump shares wholesale. "If something is really bad, maybe it's better to sell it," Mr. Gau says. "But do I think AT&T is going to be around for the next 50 years? Probably."

Go for Dividends

Above all, advisers urge retirees to find investments that establish a steady income. To many, this means plain-vanilla bonds, but there are actually a number of dividend-paying options out there.

One increasingly popular vehicle: real-estate investment trusts, companies that invest in real estate and must pay dividends of at least 95% of their net income to shareholders. REITs were averaging a 6% yield in July.

But, be warned: The underlying shares have seen some wild swings in value, which could be trouble if you need to cash out quickly. After posting an average total return of more than 36% in 1996, REIT stocks gained only 9.1% this year through July 31, according to the National Association of Real Estate Investment Trusts.

Advisers also recommend Government National Mortgage Association bonds, which are yielding over 7%. While advisers like Ginnie Maes because they have the backing of Uncle Sam, the bonds are sensitive to interest-rate fluctuations. When rates fall, many homeowners refinance their loans, and retirees holding Ginnie Mae bonds can end up with a lower income from the bonds than they originally expected.

Advisers with clients who can't handle a lot of volatility -- but who want equity exposure to build their assets -- are suggesting convertible bonds. Convertibles are like other corporate-bond issues, but investors can exchange them for the company's stock. When that stock rises, its convertible follows, but when the stock falls, the bond's fixed-income characteristics cushion the blow, hence comforting nervous retirees.

Meanwhile, many advisers concentrate on Treasurys and tax-free municipal bonds, which are particularly attractive for the wealthy, who face higher income-tax rates. Advisers often set up "laddered" portfolios containing bonds maturing at different intervals. That way, retirees regularly have mature bonds to cash if they need them, and they "don't have to follow Greenspan," says Steve Garrett, vice president and manager of financial planning at St. Louis-based broker A.G. Edwards Inc.

Another option for retirees who want regular dividends -- but who want to remain liquid in case of emergency -- is bond funds. If you want to sell individual bonds before maturity, you must find a buyer, points out Alan Weiss of Regent Retirement Planning Inc. in North Haven, Conn. But with a bond fund, you can simply cash out. And, overall, a portfolio stockpiled with individual securities can require more maintenance than one relying on mutual funds.

Multisector funds provide easy, one-stop diversification among government, corporate and international bonds, advisers say. Just as in the stock market, diversification in bonds is important for retirees who don't want to put all of their eggs in one basket. For example, corporate bonds don't respond the same way emerging-market bonds do to market fluctuations.

Still, some advisers would rather buy individual securities instead. Financial planner Susan Kaplan in Wellesley, Mass., likes to put her clients in higher-quality corporate bonds rather than in bond funds.

"In the bond area, returns are never going to be that high, and I don't like the expenses of a fund," she says.

Stay in Stocks

Advisers say retirees need some equity stake so that their assets keep pace with inflation -- especially now that many people are retiring earlier and living longer.

"I tell people, putting all of your money in the bank is how to go broke safely," says Mr. Gau.

The best way to mitigate the risk of the market is to buy stocks through a mutual fund. On the whole, advisers say, a good asset-allocation plan is more important than any single product or asset class, but some funds are especially strong magnets for retirement assets. In the interest of providing regular payments to retirees, advisers recommend equity-income and growth-and-income funds.

"Even if the stock market falls off a cliff, they won't have to sell the thing at a loss to generate income," Ms. Kaplan says.

Adds Mr. Garrett of A.G. Edwards, "My dream is that it would be wonderful to retire and have your whole source of income be dividends. And you can always switch to bonds if you can't stomach the peaks and valleys" of the market.

Large-cap funds are also popular, in part because they're an easier sell for retirees who are wary of investing in unproven companies, advisers say. Investors who are unfamiliar with the stock market are at least familiar with the names they see in a large-cap fund portfolio.

Value-stock funds are in demand as well, since they can provide consistent returns with less volatility than growth-stock funds.

"What I like to do with retiree portfolios is keep the risk rating at or lower than the average of the market, and a value fund can do that -- especially in a down market," says Mr. Rosenberg of ARS.

On the other side of the equation, many advisers shy away from both sector and aggressive-growth funds for retirees unless their clients have a lot of money they need to diversify. These types of funds tend to be more volatile then most, and an unnecessary risk for retirees, who would have a much harder time replacing their assets than a working investor.

For diversification's sake, international funds are also crucial to a portfolio, advisers say. "I'm a patriot," Mr. Gau says. "I think the U.S. is the best, no question. But it's not the only country out there that has great buys."

Here as elsewhere, diversification is important. Many planners avoid single-country funds, and some, like Mr. Gau, avoid regional plays like Latin American funds. If clients want such exposure, he directs them to more general emerging-market funds.

But be careful, Mr. Weiss says. Investors should know the difference between international funds, which place all of their assets overseas, and global funds, which invest everywhere, including the U.S. In addition, Mr. Weiss warns investors "you'd be kidding yourself" if you thought foreign markets wouldn't stumble during a U.S. market correction.

Look to Annuities

Although not nearly as widely known as mutual funds, variable annuities offer some of funds' advantages -- and add an income component that's attractive to retirees.

Variable annuities are insurance contracts wrapped around stock and bond mutual funds, allowing your investments to grow tax-deferred. And when you're done growing assets in the funds, you receive a guaranteed income based on the value of your investments and your life expectancy.

Moreover, contracts have other bonuses that make them an interesting choice for retirees. Some let you withdraw from your annuity to cover unexpected hardships, such as nursing-home stays. Most offer death benefits, which guarantee survivors will receive a minimum amount if the contract holder dies while the variable annuity is still in the accumulation phase. Death benefits come in many forms, from a principal death benefit, which guarantees only the original investment regardless of how the value of the underlying funds rises or falls, to a stepped-up benefit, which provides survivors with the market value of the contract as evaluated every few years.

Advisers say variable annuities are only for investors who have maxed out investments in other tax-deferred vehicles, such as IRAs and 401(k) plans. Also, since you want to give your investments some time to grow, advisers say variable annuities are best for people with 15 or more years before they need income from the contract. Usually, that means buying the product well before retirement.

The biggest downside, advisers say: the expenses. Most variable annuities are sold by broker-dealers and insurance agents, who receive commissions. And contract expenses for the vehicles averaged 2.18% in July, according to Morningstar Inc. Then there are the back-end surrender charges, which penalize investors for removing money before a certain number of years have passed. And, just as with other tax-deferred investments, investors can't withdraw assets until age 59&micro;, or they owe the government a 10% penalty -- an important consideration for early retirees.

Meanwhile, many advisers say variable annuities have lost their appeal with recent capital-gains tax cuts. Variable-annuity withdrawals are taxed as ordinary income rather than capital gains, meaning a steeper bill for higher-income investors.

Other advisers counter that retirees usually have a lower income anyway, thus reducing their taxes, and that variable annuities are attractive for many reasons.

Instead of variable annuities, some money managers use fixed annuities -- which provide a relatively predictable income and don't fluctuate in value the way variable annuities can -- as part of the nonequity component of their clients' portfolios. However, low interest rates are making fixed annuities less appealing than they were a few years ago, with average annual gains under 6%. At that rate, fixed annuities may leave a retiree vulnerable to inflation.

Plan Your Estate

One of the most important components of retirement planning, especially for retirees with large pools of money, is figuring out how their assets will be divvied up after their death. There are many ways to ensure their heirs aren't overly burdened with taxes or red tape.

First, there's a variation on variable annuities: variable life insurance, which also makes use of tax-deferred investments in stocks, bonds and other options. Investors can borrow against the policy without reducing its value, leaving money for heirs. As with variable annuities, this is recommended for investors who are still a number of years from retirement, or for those who expect a long retirement, since the assets take time to accumulate.

At the same time, investors need to remember that variable life is not like other life insurance. Investments can get hit by poor performance of the underlying issues.

A more traditional form of insurance that has been gaining in popularity lately is survivorship, or second-to-die, coverage. Such policies cover both spouses and transfer assets to the surviving spouse without triggering taxes. Upon the death of the second spouse, heirs can use the proceeds of the insurance to pay off federal taxes levied against estates of more than $600,000 (under the new tax laws, the estate-tax threshold will rise to $1 million over the next decade). As an added incentive, the premiums for survivorship life are less expensive than for two policies, because they're based on the combined life expectancies of two people.

To keep the proceeds, or death benefits, of a large life-insurance policy out of the estate, wealthy retirees often turn to irrevocable life-insurance trusts, which act as both the owner and the beneficiary of the insurance. However, trusts can be expensive to set up and time-consuming to maintain, some planners warn.

Then there are family limited partnerships, which let you pass some assets to heirs "at a discounted rate -- which is why they're under scrutiny," says Susan MacMichael John, an adviser at Financial Focus in Wolfeboro, N.H.

Here's how it works. A retiree transfers assets, tax-free, to the partnership while he or she is still alive, paring down the estate to help heirs avoid future hefty estate taxes. Children receive "gifts" each year in the form of limited-partnership interests.

The Internal Revenue Service is examining the structure of such deals because family limited partnerships allow wealthy investors to give more than $10,000 annually to each beneficiary, the current limit before gift taxes apply.

Ms. Kaplan, the Wellesley, Mass., planner, notes that the situation for using the partnerships has to be "absolutely perfect." Retirees may have to rely on children controlling the partnership for income, leaving room for abuse by bad seeds. In addition, these partnerships are complex and illiquid.

Of course, there are cases where you want to will your assets to an organization instead of individual heirs. With a little work, you can do that and still make money in the process.

Take charitable remainder trusts, which are used by retirees who have relatively illiquid assets, such as highly appreciated stock, real estate or a business. Investors place their assets in the trust for a charity. The trust can then sell the assets tax-free and use the proceeds to distribute income to the benefactor. After the investor's death, the remaining money goes to the charity.

Other Vehicles

Some advisers have preferences for products and techniques not used by their counterparts. Often, only high-net-worth individuals who have tax concerns and large portfolios to diversify use these investments, such as hedge funds and real estate.

Other products just haven't been around long enough to build a following among advisers. Take immediate variable annuities, which pay out an income stream immediately, while you're still accumulating returns on your investments. Many insurance companies believe immediate variable annuities will be wildly popular, but they're still very young and untested.

Then there are equity-indexed annuities, which put investors' money in a market index and guarantee a minimum return. These would make sense for the investor who needs asset growth but can't afford to lose any money, says Saxon Birdsong of Baltimore-Washington Financial Advisors in Ellicott City, Md.

But these and other kinds of investments won't fit most retirees' needs, many advisers say.

"I don't think they need to be trying a new exotic product, new manager or company without a track record," says Bill Carter, a financial planner in Dallas. "Let them learn on somebody else. These people are not going to be able to go out and work again. Or they won't want to."